Economics Links

Senior Bank of England officials appeared before the House of Commons’ Treasury Select Committee on 21 February to report on the state of the economy and the future path for inflation and interest rates. One topic considered was the role of depreciation.

The pound has depreciated since the referendum on EU membership in June 2016. The exchange rate index today is some 9% below that before the referendum and 15% below the peak a year before the referendum.

It had fallen as much as 14% by October 2016 below the level before the referendum and 20% below its peak, pushed down partly by the cut in Bank Rate from 0.5% to 0.25% following the referendum. In November 2017, the Bank’s Monetary Policy Committee raised Bank Rate back to 0.5%. Two or three more rises of 25 basis points are expected over the next couple of years. This has helped to strengthen sterling somewhat. (Click here for a PowerPoint of the chart below.)

But has the depreciation been advantageous or disadvantageous to the economy? Here the Governor (Mark Carney) and the Chief Economist (Andy Haldane) appeared to differ. Andy Haldane said:

A combination of the weaker pound and a stronger global economy has worked its magic. That has meant that net trade has been a significant contributor, and we expect those effects to continue over the next two or three years. … Depreciations work, and that’s how they work.

By contrast, Mark Carney said:

Depreciations don’t work. They have an economic effect, but they’re not a good economic strategy. They may be an outcome of various things … but it’s how you make yourself poorer.

Are these statements contradictory or are they simply emphasising different effects of depreciation?

Both Andy Haldane and Mark Carney would accept that a depreciation makes imports more expensive and thus reduces real incomes (at least in the short run). They would also accept that a depreciation makes exports priced in pounds cheaper in foreign currency terms and thus can boost the demand for exports.

There is disagreement over two things, however. The first is the effect on people’s real incomes in the long run. Will any fall in real incomes from higher-priced imports in the short run be offset in the long run by higher economic growth?

This relates to a second area of disagreement. This is whether a depreciation can act as a significant driver for exports over the longer term. The increased incentive on the demand side (from consumers abroad to buy UK exports) could be offset by a disincentive for exporters to become more efficient and/or to compete in terms of quality. In other words, although it can give exporters a price advantage, the crucial question is the extent to which they take advantage of this, or merely take higher profits.

The disagreements thus relate primarily to the incentive effects over the longer term.